Hans-Helmut Kotz, a senior fellow at the Center for Financial Studies, Goethe University, Frankfurt, and a resident faculty associate of Harvard University’s Center for European Studies, was a member of the board of Deutsche Bundesbank from 2002 to 2010, in charge of financial stability, markets,… read more

One Money, (Too) Many Markets

FRANKFURT – Europe’s monetary union is screeching toward the abyss, unintentionally, but apparently inexorably. Greece will most likely not meet the criteria to receive further financial assistance from its eurozone partners and the International Monetary Fund. Europeans will then need to decide whether to let Greece go. The exit option would not improve Greece’s chances of successful adjustment, and it would come at a steep price for the eurozone: it would be “in the money” – and priced accordingly.

A Greek exit could, one hopes, be managed. The European Central Bank would contain the collateral damage by flooding Europe’s banking system with liquidity (against subpar collateral). Or it will reluctantly re-launch its purchases of public-sector debt in secondary markets, capping the other peripheral eurozone economies’ interest-rate spreads relative to the core.

Thus, dire circumstances would once again force the ECB’s hand. As the strongest European institution, it is systematically vulnerable to being taken hostage, compelled to underwrite a further lease on life for the euro. In this light, ECB President Mario Draghi’s recent vow to do “whatever it takes” to save the euro came as no surprise.

Back in 1999, it seemed that Jacques Rueff, an adviser to Charles de Gaulle, had been vindicated: L’Europe se fera par la monnaie. Eleven European countries chose to give up their national currencies (or, more technically, the nominal exchange rate).

These countries understood “one money” as a quasi-physical corollary of “one market.” Independent national monetary policies in a common market were rightly seen as infeasible, given Europeans’ preference for stable exchange rates and open financial markets. This called for a single currency – and thus shared responsibility for monetary policy.

Given the euro’s current travails, it is instructive to recall arguments stressed in the run-up to monetary union. As the Nobel laureate economist Robert Mundell and others spelled out in the 1960’s, relinquishing nominal exchange rates emphasizes three alternative mechanisms to cushion regional adjustment: inter-regional fiscal transfers, intra-union migration, and, most importantly, labor markets capable of adapting to shocks.

Unfortunately, these mechanisms were anathema at the time. Conveying the message that nothing would have to change appeared to be far more attractive.Thus, Mundellian arguments were not heeded when the euro’s institutional blueprint was conceived. Indeed, the Stability and Growth Pact, like Europe’s no-bail out clause, ignored the pertinent economic theory (some say any economic theory). Regional current-account balances were interpreted as the upshot of infallible optimizing behavior by market participants, rather than, for example, the result of a real-estate bubble in Spain and elsewhere.

Only after the fact, since the fall of 2009, has it become conventional wisdom that those intra-union current-account deficits, accumulating over a decade, were untenable. Now, given monetary union, the adjustment must be carried out by changing domestic prices relative to tradable goods – that is, by engineering a depreciation of the real exchange rate.

In view of the quite substantial overvaluation in some periphery countries, this will be a time-consuming process. (Germany needed almost a decade to adapt to a smaller property bubble in its new eastern Länder in the early 1990’s.) But it is difficult to imagine that market participants will have the required patience. That is why supporting the euro requires forceful and credible crisis containment – whatever it takes.

But the ongoing crisis also highlights a second design flaw, unacknowledged in Mundell’s argument: the challenges arising from integrated financial markets (including those for the credibility of the no-bail out clause). Under normal circumstances, unimpeded cross-border capital flows come with all of the advertised benefits in terms of better resource allocation and higher productivity. In the wake of the crisis, however, given the shared fate of national governments and banks, a significant home-bias re-emerged. Ring-fencing became national supervisors’ default option, and monetary conditions became re-segmented along national lines.

This translates into a significant disparity in financial institutions’ funding costs. The immediate upshot is a substantial divergence in firms’ cost of funds, with many small and medium-size enterprises even losing access to credit completely. As a result, capital expenditure – already a fragile proposition, given weak demand – has plummeted, triggering a vicious circle of shrinking GDP, lower tax revenues, higher expenditures, and further destabilization of public-debt positions.

The problem is not only that such heterogeneity in funding conditions renders a common monetary policy difficult to conduct. More important, given that some regions now face interest-rate spreads that are the functional equivalent of having their own currencies (without a central bank), some eurozone members might at some point wonder why they should not formalize what is de facto a reality. Market participants already do, to a degree.

None of this is inevitable. The euro was not created for purely economic reasons. If it is deemed a worthwhile project, and is viewed as mutually beneficial to all participants, the eurozone could be made viable. In order to achieve this, certain minimum conditions must be met. In addition to flexible labor markets, a viable eurozone presupposes a (minimal) fiscal insurance mechanism. And it calls for not only common financial regulation, but also for eurozone-wide supervision of financial institutions, including common deposit insurance and a shared bank-resolution scheme.

This is a tall order. And it will take time to implement. But the immediate short-run alternative – letting Greece (and potentially others) fall by the wayside – would carry a substantial price. Periphery countries would be forced to pay a significant premium to compensate investors for assuming a redenomination (partial default) risk. And, with that, the eurozone would become as vulnerable as any fixed exchange-rate system has historically proven to be.

Comments

The eurozone's original sin was the ECB's single mandate. If the central bank had a full-employment mandate like the Fed, Jens Weidmann wouldn't have a leg to stand on. As it is, he is within his rights to reject any other desiderate besides price stability. Either change the mandate or outvote Weidmann.

The writer of this interesting overview article writes:"..None of this is inevitable. The euro was not created for purely economic reasons. If it is deemed a worthwhile project, and is viewed as mutually beneficial to all participants, the eurozone could be made viable. In order to achieve this, certain minimum conditions must be met. In addition to flexible labor markets, a viable eurozone presupposes a (minimal) fiscal insurance mechanism. And it calls for not only common financial regulation, but also for eurozone-wide supervision of financial institutions, including common deposit insurance and a shared bank-resolution scheme..."I think the minimum conditions for keeping the Euro project and the whole European Union alive and sustainable is full integration into a federal Europe.Without rock solid foundations, and structure everything else would fall short.Now there is a lot of fear, anxiety about a full integration, especially with the rhetoric we hear these days, the black&white political vision of today's leaders, assuming that everybody has to become like Germans to make it work, extreme political parties bringing in their usual agendas and fear incitements, and so on.On one hand we do not have a choice, even now we live in a totally interconnected, global, and fully interdependent network, the main decisions in our lives are not made locally, not even nationally. The problem is not the connections but how we use them.At the moment all the planning and decision making is based on subjective self calculations, without taking the whole, or other participating elements into consideration, we only care about the others as much as we can use, exploit them for our own gains.An optimal supra-national union/federation works in a way, that the priority is on the sustainability and optimal function of the whole system, and in the meantime all the relative strength and weaknesses of all participating elements are taken into consideration, so all members could contribute to the whole with 100% of their abilities, and receive their rewards accordingly. Nobody loses their individuality, colors or traditions, but all can put their own piece of the puzzle into the perfect total picture.An optimal Union is based on mutual responsibility, and based on the overall governing laws of nature thriving for homeostasis, as any living creature or living system can only succeed, be prosperous, survive in evolution in such manner.And since we are not above the system we exist in, but are parts of it, these laws apply to us just as well.We have all the blueprint laid out in front of us already by multiple experts, scientist, we simply have to start using it.

Alberto Bagnai, ET AL
want the Greek government to abandon the euro – and all other eurozone members to follow suit.

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